Determinants of Index Insurance Uptake Alexandros Sarris Professor, department of Economics, National and Kapodistrian University of Athens Greece, and Senior Fellow FERDI Presentation at the FERDI organized workshop on “ Microfinance products for weather risk management in developing countries: State of the arts and perspectives” Paris, June 25, 2014
Plan of presentation • An insurance demand model • Factors affecting demand for WII • Empirical ex-ante demand for Weather Index Insurance (WII) • Ex-post demand for WII
A theoretical model for the willingness to pay (WTP) or demand, for Weather Index Insurance (WII) by a farmer who insures in the first period of a year, and is compensated in the second period • Household WTP for insurance B can be written theoretically as follows Where: r is the return to the insurance contract per unit area insured q is the amount of area insured R tj j=1,2, denotes the value of resources available to the household at the beginning of period tj , namely previous period assets plus current period income from these assets ΔR is the deviation of current (ie in time tj) resources from expected, or long run values β denotes the amount of smoothing that the household does in each period. If β=0, then there is perfect smoothing. If β = 1, there is no smoothing at all, and current consumption moves exactly as current resources ρ is the coefficient of relative risk aversion
Theoretical predictions • First term is actuarially fair value of the insurance • The larger is the degree of risk aversion (larger value of ρ ), and the smaller is the degree of consumption smoothing (larger values of β ), the larger is the benefit of or demand for insurance. • The larger is the degree of (unpredictable) deviation of resources from normal (positive or negative), the larger is the WTP for insurance. • The larger is the variance of the return of the insurance contract, the lower the WTP for it. • The WTP for an insurance contract is larger with a more negative correlation between the return to insurance and the second period resource uncertainty.
What determines uptake • Uptake of insurance will then occur whenever these benefits are larger than the insurance premium, itself function of the cost of providing insurance (including assessment of damage, when needed) and of a loading factor m : • Uptake = 1 if B ≥ premium = cost (1 + m ) • = 0 otherwise. • From this, we see that there are six categories of determinants of uptake of an index-based insurance: – Quality of the insurance product/basis risk – Availability of other insurance mechanisms/risk layering – Expected gains from insurance – Lack of knowledge and trust/level of contracting – Learning from stochastic experiences – Cost of index insurance, price, and subsidies • Among these, there are three determinants of uptake that are specific to index insurance relative to loss-based indemnity insurance: Basis risk Learning and understanding Cost and price.
Quality of the insurance product: Correlation between insurance payout ( rq ) and shock on resources (Δ R t2 ) • Weather risk may not be the largest risk the farmer perceives and he may need more comprehensive insurance • Farmers are generally interested in income and wealth losses and not particularly about hedging rainfall shortages. This implies that a WII to be desirable has to correlate not only with the yield of one or more particular crop, but that these crops must be a significant share of the total income of the farmers. • Basis risk • In the above formulation basis risk can be thought of as the lack of negative correlation between the returns to the insurance z and the deviation of current resources R from trend. • Quality of contract design
Ability to smooth consumption (β) • The farmer has other existing insurance mechanisms such as self-insurance, family, other social network, etc. In the model above this manifests itself in low magnitude of the consumption smoothing parameter β .
Discount rate or credit constraint (δ) • Insurance not desirable if not related to credit or other investment mechanism • Lack of flexibility in terms of payment of premium or indemnity • Time inconsistency (δ) combined with cash flow problems Credit gives a farmer the possibility of having resources now, with a promise to pay later. On the contrary, insurance implies a cash outflow now for an uncertain return later.
Lack of knowledge/trust on distribution of payout and correlation with shocks • Lack of trust in the insurance provider • Ambiguity aversion An ambiguity averse agent may not know the probability distribution of the insurance return r of the WII, and this is quite likely for a new product that has no known (to the agent) history of application. In such a setting the ambiguity averse agent will prefer to not take up the contract rather than purchase one that is not clear when and how it will compensate. • Technology and institutional setup are difficult to explain and understand
Learning from stochastic experiences • Recency bias: Demand depends on recent experiences • Role of shocks (positive effect on the need for insurance) and role of payouts (negative effect of no payouts)
Cost and price • A recognized advantage of index-based insurance is lower implementation costs compared to traditional loss adjustment-based insurance as it avoids the administrative costs of loss assessment and moral hazard, as well as the actuarial cost of adverse selection. Price however remains an issue for uptake. In spite of lower costs, prices may internalize a “data rent” as risks are initially poorly informed with existing data, translating into high insurance company loadings.
Estimation of ex-ante and ex-post Demand for Index Insurance in Ethiopia (EPIICA project 2011-14). • Used a Contingent Valuation technique, asking farmers whether they would be willing to purchase a specific insurance contract at prices that were randomized across survey respondents. • Insurance was framed as covering the cost of inputs: fertilizers and improved seeds. • Hypothetical insurance contract would pay 1000 birr per timad insured in 1 out of every 4 years, so actuarially fair price is 250 birr. • Premiums used in the CV survey question were randomized to 50, 100, 150, 200, and 250 birr. – For those who DID want to purchase insurance, we then asked how many timad they would insure. 12
Estimation of Interlinked Demand: • For those who DID NOT want to purchase a standalone insurance contract (premiums paid in cash up front), we then asked the following: – Would you become interested in purchasing insurance now if you were to be able to receive the 1000 birr worth of inputs on credit rather than having to pay for them in cash up front? (basic interlinked product) – Would you become interested in purchasing insurance if both the inputs and the insurance premium were financed by credit? (full state-contingent loan). • Comparison of these three questions lets us examine the stated willingness to pay for standalone insurance, as well as the additional demand created by interlinking. 13
Estimates of the ex-ante WTP for weather index insurance (values for – ¼ below or above normal rainfall or frost)
Demand curves for each type of insurance : Demand for Insurance, by Price Percent willing to purchase insurance 90 Elasticity = -.08 80 Elasticity = -.15 70 60 Elasticity = -.27 50 50 100 150 200 250 Price Standalone Interlinked Interlinked with premium financed Actuarially fair price is 250 birr Demand for the interlinked products is higher and less price elastic. 15
Why do people not purchase standalone insurance? Reasons for not purchasing insurance 6.55% 36.68% 26.2% 2.183% 2.62% 6.987% 18.78% I cannot afford to pay any amount for rainfall insurance I am short of funds in the period before planting Declines in rainfall , floods or frosts do not hurt me too m I have other means of covering my losses due to inadequate r Major declines in rainfall do not occur too often I do not want to pay for something which I am not sure I wil I do not trust the insurance companies Primarily lack of income, and insecurity about the product itself. 16
Caveats: • Field studies almost invariably find high STATED willingness to pay for index insurance, and then low REVEALED demand when people are asked actually to pay for it. • So, probably shouldn’t believe the absolute numbers on demand. • Henceforth, we focus on ex-post variation in the uptake of WII 17
Uptake results first year (2012) 49 villages in final study sample (out of 120) 34 treatment villages (17 standalone, 17 interlinked) Sales achieved in 23 treatment villages (of 34) Problems of information and Cooperative Union non-acceptance of interlinked loans Each of 20 study households in treatment villages received a random voucher (five values 0-500 birr) for the insurance
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